Tuesday, December 12, 2017

Why Aren't Arbs Narrowing the Spread Between the Bitcoin Spot Market and the Futures Market?

As much as bitcoin bulls might want to use the smooth start of trading to contend that the cryptocurrency and its price are more solid than critics contend, the real test won't come until Jan. 17. That's when the Cboe's first main contract expires. And as any futures trader knows, getting out can be trickier than getting in.

There already are some troublesome signs. On Tuesday, the price of the January contract was down $815, and volume was much lower in the second day of trading. But the biggest problem could be the persistent, and unusually large, gap between the price of bitcoins and the futures contract. That spread was more than $1,000, or 6 percent, as of Tuesday morning, though it had been double that a day earlier.Gaps often persist between current and futures prices, but they tend to be relatively small. That's because they normally create nearly risk-free arbitrage opportunities -- often called the carry trade. Buying the commodity or currency, in this case bitcoin, and selling the futures allows you to lock in a profit between the difference of the two when the contract expires. As more traders pile in to capture this spread, that gap tends to close, and you'd think that would be the case with bitcoin: Opportunities for 6 percent monthly returns aren't that widely available these days, or ever. That raises the question of why traders weren't rushing in to grab this obvious free lunch.

Arbitrage traders on bitcoin's first full day of trading seemed reluctant to get in.

Here's where the exit problem could be coming in. The Cboe's contract is tied to the price of bitcoins on a single exchange, Gemini. (CME Group's contract will be based on an average price of four different exchanges.) Billions of dollars of bitcoins trade a day, but only a fraction of that on Gemini, perhaps a few hundred million on a good day. More than $70 million in bitcoin contracts have already been bought. That could create a lot of selling when those contracts expire.On top of that, hedged traders could try to drive down the price of bitcoin on Gemini shortly before the contract expires in order to buy it back cheaply and sell it on another exchange at a higher price, according to Timothy Tam, a co-founder of CoinFi, a cryptocurrency market intelligence platform. If all that selling instead causes Gemini to freeze up, or worse, creates essentially a run on the exchange, arbs wouldn't be able to get cash back for their bitcoins, wiping out any profits from the carry trade and then some...

A full run on the Gemini exchange, which is backed by the Winklevoss twins of Facebook and now bitcoin fame, seems unlikely. But the longer the gap in the bitcoin futures market goes unexploited, the more it suggests there are costs and risks the bulls may be missing.